Column : How the Fed feeds India

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: This last week, the US Federal Reserve cut its target rate more than expected to an unprecedented level close to zero. A few days later, the Bank of Japan sought to move in tandem and go on to Act 2 of its nineties’ quantitative easing (QE). What were the motives, why a shift in stance now, and what will be the consequences?

It might seem an academic exercise to analyse the Federal Reserve’s monetary policy actions last week, but it is not. It will have a deep impact on India’s economic future in the next year, even more than the measures now being taken by India’s policy authorities. A back-of-the-envelope calculation shows that India’s exposure to global markets (exports of goods and services) in 2007-08 was $223 billion (or about Rs 11 lakh crore; India’s GDP was Rs 47 lakh crore, for reference). A fall of 20 percentage points in exports growth in 2008-09 means a drop of Rs 2 lakh crore in potential income, far beyond anything that our stimulus packages envision. So what the Federal Reserve manages to do will have significant implications for India’s economy. If we accept this, we need to understand the implications of the measures announced by the Federal Reserve in much greater detail.

Recall the string of interventions by the Fed since September 2007. The chart shows that despite the significant liquidity that had been injected since then, the Fed had managed to keep the effective federal funds rate close to the relevant Target till the markets blew up in mid-September, after the collapse of Fannie Mae, Lehman Bros and AIG. After that, the Fed has effectively been in a quantitative easing mode and the effective rates have been close to zero since November.